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3 Great Ways to Pick Stocks

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Having worked in the equity markets for awhile now, with a primary focus on finding profitable stock-picking strategies, I sometimes feel like the keeper of great stock-picking ideas. But as the holiday season is upon us, I’m in a giving mood -- unlike Scrooge -- and will gift you three great ways to pick stocks. (And no, I wasn’t visited by the Ghosts of Markets Past, Present and Future. Although a visit by the ghost of Market Future might be nice. Or maybe scary.) What’s especially good about these three methods is that when combined, they complement each other well.

In the previous two articles you’ll remember that I discussed the merits of the Research Wizard as an essential stock picking tool for the individual investor to create and test ideas. So today I’m going to give you an example of how to develop a stock-picking strategy within Research Wizard using three components.

First, it’s very important to start with a good ranking or rating system. Most of the time, there’s a lot of research already committed to a rating, and starting with a good working foundation is a great way for you to save time. Examples of these are broker stock ratings or the Zacks Rank. I’ll use the Zacks Rank since it’s more comprehensive than broker ratings and also has a great track record for selecting stocks.

Second, look for stocks that the market judges favorably too. Nothing’s more frustrating than discovering a great company, but the stock price just doesn’t go up. So it’s a good idea for the stock to have good price appreciation over the past twelve months. Numerous research studies have shown that winning stocks continue to be profitable in the future. It sounds a little too easy, but it’s effective and very persistent in the stock market. Why wouldn’t this effect go away if it’s so effective? Well, that’s why it’s called the Momentum Anomaly. Check it out.

Finally, I think it’s a great idea to buy things at a bargain or discount. You wouldn’t pay more for a comparable holiday gift, so why do it for stocks. So let’s add a dash of value by looking for stocks with a low price-to-sales ratio. The P/S ratio is a measure of how much you’re paying for each dollar in corporate revenue. Obviously you want to pay as little as possible. For example, if stock A has a P/S ratio of 1 and stock B has a ratio of 2, then you’d pay twice the amount per dollar of sales if you bought stock B instead of stock A.

So at this point, if you read my last article, you’re probably thinking: it all sounds good, but how effective is this strategy? Using Research Wizard, I built this strategy and tested it monthly from the beginning of 2000 through the end of October 2011. Over this time frame, the S&P 500 returned a compounded annual return of 0.1%. (So people are right when they say the equity market really hasn’t gone anywhere in nearly twelve years!)

However, the strategy I suggested returned a compounded annual return of 16.2%. So while the overall market’s wheels were spinning on ice, there were strategies out there that moved forward and were highly profitable. You simply needed to find them. Remember also that if you have a low number of stocks in your portfolio, you’re going to have more volatility. For example, the strategy that I outlined contained only 10 stocks and, thus, had 64% more volatility than the S&P 500, with its 500 stocks. In this case, the volatility was worth it.

Here’s a method for finding highly rated stocks with good momentum at a reasonable price:

First, start with only US common stocks.

Next, create a liquid, investible set of the stocks with the largest 3000 market values and average daily trading volume ≥ to 100,000 shares (if there's not enough liquidity, it’ll be hard for you to trade it).

Add another filter by selecting those stocks with a Zacks Rank = 1. (Let’s stick with only the best rated stocks.)

Select the top 50 stocks with the highest return over the past 52 weeks. (We’re looking for stocks with great price momentum over the last year.)

Select the top 10 stocks with the lowest price-to-sales ratio. (Lower means you want to pay less per unit of company revenue.)

Aetna, which is a Strong Buy per the Zacks Rank, operates as a diversified health care benefits company in the US. The stock price of this company has been going strong and remains a reasonable value based on its price-to-sales ratio.

Newpark, which provides fluids management, waste disposal and well site preparation products and services to the oil and gas exploration and production industry, is reporting strong financial results and makes the list due to its solid rating, great price momentum, and good price/sales ratio.

The stock price of this retailer has been jumping yet still remains a good value. Genesco, which sells footwear, headwear and sports apparel, has experienced a surge in earnings and profitability in the third quarter.

Primoris, a specialty contractor and infrastructure company, provides a range of construction, fabrication, maintenance, replacement and product engineering services. With November’s announcement of record quarterly results and new contracts worth close to $200 million, the stock of this company has been flying high and should continue well into 2012.

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